The Penny Stock Problem

Penny stocks, also commonly referred to as small-cap
stocks, are loosely defined as a stock with a share
price below $5. The US Securities and Exchange Commission
(SEC) defines them as such, however, penny stocks are often
defined as a stock with a share price below $1 by those in
the investor community.

Penny stocks are the stock market’s equivalent of junk
bonds in the bond market. Investing in penny stocks can be
much riskier than trading mid to large-cap stocks.
Severe and long lasting drops can quickly occur, with
little warning. Conversely, penny stocks can yield rapid
gains, sometimes up to +1000% in the matter of days. This,
coupled with the low price, often lures new investors into
trading penny stocks.

The difference between penny stocks and blue-chip and mid-
cap stocks is important to understand before you invest.
Whereas the market performance or normal mid to large-cap
stocks is driven primarily by fundamentals, penny stock
performance can be much more pliant to investor
speculation. A company’s market capitalization (cap)
derives from its stock price multiplied by the shares
outstanding. This number is therefore the sum dollar value
of all of the company’s shares at that time. So a penny
stock has less shareholders than a mid-cap stock and
trades on a far smaller volume per day. This is why penny
stocks are so speculative. Any sudden change in demand or
supply for the stock will be felt quickly throughout the
entire framework. As earlier stated, this can be good (less
people to share the profit with), or bad (less people to
shoulder the loss). Penny stocks are much more volatile
than mid or large cap stocks and this is why many investors
regard them as a gamble.

One of the justifications for investing in penny stocks is
the notion that many of today’s blue-chip stocks, such as
Google and Microsoft, were once penny stocks. This is a
misconception, though, because after you adjust for stock
splits, it becomes apparent that these company’s shares
were actually almost never trading on par with penny
stocks. Investors often overlook this fact and look for the
next Microsoft when buying penny stocks.

Because of the lower trading volume, penny stocks lack
“liquidity,” which means that investors can find it more
challenging to buy or sell. Just like with junk bonds, lack
of liquidity opens the gate to stock manipulation by
fraudulent investors.

Many novice investors are eager to jump into the penny
stock trade because of the potential for enormous gains.
Just as with gambling, though, an investor must be ready
to lose everything that they have invested when dealing
with penny stocks. Furthermore, historically speaking,
huge rises in penny stock value are incredibly rare. Even
in the few instances where this has happened, the price is
usually unstable, and falls as quickly as it rose. If you
are new to investing, be sure to research the company in
which you are investing. Analyze their fundamentals and
be aware of the potential risks involved in the penny
stock trade.

Taft Coventry is an Associate Partner at the most trusted source for online money making information, [http://MadisonandMonroe.org] Visit [http://www.MadisonandMonroe.org] for online business information, articles, and financial product reviews.

Author: Taft Coventry
Article Source: EzineArticles.com
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